A 1031 exchange is a powerful tax-deferral tool, provided you meet strict IRS deadlines. In response to COVID-19, the IRS has temporarily loosened those deadlines. Here's what a 1031 exchange is and what the IRS’ new moves mean for real estate owners and buyers.
What is a 1031 exchange and how does it work?
Simply stated, a real estate owner swaps one “like-kind” property for another in an IRS-authorized process called a 1031 exchange.
Any real estate owner has the ability to sell a property that has appreciated in value and defer any capital gains taxes. If the entire exchange is completed within the strict 45-day nomination period and the 180-day timeframe as required by the IRS, taxes are deferred.
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The catch is, the seller must buy another “like-kind” property, following all guidelines of IRS Code 1031. Like-kind requirements for real estate are broad to include land, houses, apartments, office and retail buildings, warehouses and any other form of real estate held for investment purposes. In other words, an investor could choose to swap an office building for apartments.
Let’s say an investor sells a property and nets a $500,000 profit. If the investor does not exchange, then the total combined exposure for federal and state taxes, plus depreciation recapture could be as much as 30%, depending upon the seller’s basis in the property. But if the investor exchanges, the full $500,000 can be transferred into a replacement property. As the investor continues to exchange properties over time, this equity grows as capital gains taxes continue to defer.
It's all about timing
A 1031 exchange must follow strict deadlines. Under normal conditions, the clock starts ticking when the relinquished property closes. Then, the seller (or “exchanger”) has 45 days to identify qualified replacement properties and 180 days to purchase the replacement property. It's important to note that this “swap” must be completed in 180 days, not 45 days plus 180 days.
Unique challenges for property buyers and sellers during COVID-19
Although it seems like the world has come to a complete standstill, investors are still actively buying and selling real estate, albeit at a reduced number of transactions. My firm is a real estate sponsor and syndicator; you'd be surprised how many investors currently have 1031 exchanges in progress. Many more hope to either sell or “swap” before the close of this tax year.
Real estate investors are facing unique challenges because of COVID-19. Lending requirements are stricter as lenders evaluate the recent drop in income collections and add debt reserve requirements. Site inspections have become nearly impossible, with apartment residents sheltering in place and retail stores and office spaces closed.
For buyers, the challenge now for a 1031 exchange is trying to find a good replacement (or “upleg”) property. Many sellers have pulled their properties off the market waiting for a normalization period — and that’s why some recently announced IRS extensions are so important. A number of deadlines have been pushed that will help investors in exchanges and those looking to buy more property.
The IRS’ new extension: What we know and what we don’t know
The IRS issued a notice on April 9, 2020, providing “additional time to perform certain time-sensitive actions.” This deadline relief is specifically for 1031 exchanges and opportunity zone investments that are currently underway.
For any property owner who initiated a like-kind exchange by selling the old property — and for whom either the 45-day identification deadline or 180-day closing deadline falls between April 1 and July 15 — the deadline has been extended to July 15. For example, an exchangor who originally had a 45-day identification deadline of April 1 now has an extension to July 15 (the requirement to close the sale within 180 days, or mid-August, remains). The extension allowance would not apply to exchangors with original identification or closing deadlines beyond July 15.
The COVID-19 IRS 1031 exchange deadline extension does still have some gray areas, however, as the guidance provided on this issue prompts new questions. For one, there is no guidance to how deadlines after July 15 will be adjusted. Also, investors are still waiting for individual states to go along with federal guidelines. When you exchange, you’re also deferring state taxes. That’s the biggest uncertainty as of now.
1031 exchanges are always a complicated investment strategy, and will be especially so for the 2020 tax year. Sophisticated investors know that having an established team of experienced professionals in place is critical to ensure all of the IRS requirements are satisfied.
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